In my Money Week column this week, I'm arguing that Obama's banking reforms will just tee-up the next crisis. Here's a taster.
Where will the next financial crisis come from?
As the global economy steadily, if slowly, recovers from the credit crunch, plenty of attention is quite rightly being paid to the next shock. Such is the fragility of the financial system, there isn’t any shortage of candidates. Perhaps it will be a sovereign debt crisis, led by countries on the brink of default such as Greece. Maybe an implosion of the Chinese economy, which is increasingly the sole engine of world trade. Or it could well come from central banks withdrawing the stimulus the have been pumping into the system, so provoking a fresh round of bank collapses.
In reality, however, the answer is probably none of the above.
The seeds of the next crisis are being sown in the political and regulatory response to the current one. The new taxes being levied on bankers and their bonuses in the UK, the US, and elsewhere, are going to drive the financial system offshore and push debts off the balance sheet. Risk won’t be abolished, it will simply be driven underground. At some point it will blow up – creating a fresh round of trauma for the world economy.
This month, President Obama has put forward a tough new tax on the banking system. The Financial Crisis Responsibility Levy is craftily constructed, imposing a 0.15% levy on the total liabilities of the 50 largest financial institutions in America. It is estimated that the tax will raise around $9 billion a year, and, over ten years, will re-coup the bulk of the money the government had to spend bailing-out Wall Street during the crisis.
In the UK, the Government has imposed its one-off tax on bankers bonuses, designed to confiscate the bulk of the money London’s bankers might have earned during 2009. Other taxes are being discussed. Lord Myners, the City minister, has said that Britain may well impose a levy on its financial system similar to the American one. Angela Merkel, the German Chancellor, praised the tax, but said she preferred an ‘international levy’ on financial transaction. The chances are that other countries will follow the UK and US leads.
It is impossible not to sympathise with the thinking behind the new taxes. The banks have been bailed out with massive taxpayer support, and have shown few signs of contrition. They appear intent on going straight back to their bad old ways. At the very least the taxes may assuage public anger, and build up funds to deal with the next crisis.
And, in fairness, there are ways the taxes will help. The US levy will discourage what might be called the ‘Fred Goodwin syndrome’ – massively increasing the size of your balance sheet by ramping up leverage and offering more and more credit to everyone who walks through the door. The more liabilities you take on, the more tax you pay. On top of that, it will favour small banks, who will be exempt, over bigger ones. Insofar as it encourages smaller, less risky banks, that will be a good thing.
In the UK, everyone acknowledges that the bonus culture played a role in creating the crash, so it makes sense to impose taxes on what bankers get paid: it won’t fix the problem by itself, but if it brings some sanity back to bankers wages, it will help.
The trouble is, there are big risks as well.
Both taxes may well drive more and more business both offshore and off-balance sheet.
Take a look at the way they work.
Obama’s levy sets up a very clear incentive to use off-balance sheet vehicles. If you can roll-up your liabilities into a new company, and park it somewhere else, so that they don’t appear on the balance sheet, you can avoid the tax. We have to assume that if you give bankers a big incentive to indulge in some fancy financial engineering, they’ll jump at the chance. The result? Liabilities that used to be on the bank’s balance sheet, where everyone could at least see them, will suddenly disappear behind a brass plaque somewhere in the Cayman Islands.
Likewise the bonus tax. There is already plenty of evidence that banks are reviewing whether they should base themselves in London: JP Morgan has already hinted that it may re-think its decision to build a new European headquarters in Canary Wharf because of the tax. Individuals will go to work in hedge funds based in Zug or Malta instead of working for a London-based investment bank. The result: trading and investment will move away from the UK, where it could be regulated, to offshore centres, where it will be largely invisible.
That is hardly an improvement.
In the wake of the credit crunch, it was clear that one of the main problems was the way banks had hidden their loans. It wasn’t that the losses on sub-prime mortgages were that terrible: by historical standards, they were relatively containable within the financial system. It was that they were rolled up into products of such bewildering complexity that nobody could figure who owed what to whom, or how much money might have been lost. As a result, the circuits of the financial system blew out, creating a crash far worse than the losses themselves really justified.
The risk now is of repeating precisely that mistake. Instead of demanding that the financial system becomes more open, and more easily regulated, the new taxes are creating a massive incentive to make it even more secretive, and even harder to monitor or control. It is very hard to imagine the results of that will be pretty.
Roll forward a few years. Imagine there are some nasty losses to deal with. Greece, for example, has defaulted on its debts. It is a bad but manageable crisis, with banks facing heavy but far from crippling losses. Except for one thing. The liabilities have all been hidden offshore. No one knows which bank is taking the hit, or for how much. Meanwhile, half the losses have been traded away to hedge funds. But who they’ve sold them on to, and whether they can survive, no one really knows, because they haven’t the foggiest who owes what or where.
A small problem ramps up quickly into a real crisis. And all because of the taxes introduced to cope with the fall-out from the last crisis. The measures may well be well-intentioned – but they are just sowing the seeds of another crisis.